The ECB's dilemma

The outcome of the ECB’s meeting on 14 September will reflect the balance the Governing Council places on more hawkish backward-looking data versus more dovish forward-looking data.

Focusing on the hawkish case, it is clear that eurozone inflation is too high. In August, headline and core inflation both stood at 5.3% year-on-year (YoY), more than three percentage points above the ECB’s 2% objective (see Chart 1). Furthermore, the recent increase in fossil fuel prices raises the risk that inflation will consolidate at levels incompatible with the ECB's objective.

Chart 1. Eurozone PPI and HICP inflation (YoY)

Source: LSEG Data & Analytics and EFGAM calculations. Data as of 11 September 2023.

Eurozone 3-month interbank interest rates of around 3.85% are about 1.5 percentage points below the inflation rate of the past twelve months. Using a backward-looking approach, such negative real rates cannot be considered restrictive and do not guarantee that inflation will return to 2%. Another 0.25% rate increase would only bring real short-term interest rates closer to 0% and this should not cause an economic collapse despite the negative effect it would have on private sector cash flows. After the Governing Council’s dramatic failure to anticipate the surge in inflation, it may prefer to minimise the risk of repeating this mistake and proceed with rate increases.

An alternative approach considers the decline in inflation from the peak of 10.6% YoY in October 2022 and the moderation of the most recent monthly changes. In addition, in August producer prices fell by 7.6% from a year before, pointing to a further decrease in Harmonised Index of Consumer Prices (HICP) inflation towards the 2% objective (see Chart 1). If that were the case, real rates computed using expected inflation would already be significantly above zero exerting significant restriction on the economy.

A decline in inflation will also be encouraged by a weakening of the economy. GDP growth was virtually zero between the last quarter of 2022 and the second quarter of 2023 (see Chart 2). In the three months to June, only the likely involuntary increase in inventories prevented a fall in GDP from the previous quarter but this bodes ill for growth in the coming months.

Chart 2. PMI composite and GDP growth

Source: LSEG Data & Analytics and EFGAM calculations. Data as of 11 September 2023.

The weakness of the economy is evident in business surveys and bank lending data. The eurozone composite PMI index fell over the summer to levels that were only seen in past recessions (see Chart 2). Net flows of European bank lending to the private sector have been negligible over the last twelve months as reported credit demand has collapsed to levels not seen since the failure of Lehman Brothers (see Chart 3).

Chart 3. EMU loan demand and recessions

Source: LSEG Data & Analytics and EFGAM calculations. Data as of 11 September 2023.

If concerns about economic growth and declining inflation prevail, it would be natural for the Governing Council to leave interest rates unchanged in September and take time to assess how to adjust monetary policy.

Markets appear to believe that the ECB will not raise interest rates much more, if at all. Futures contracts on 3-month interbank rates imply a probability of only around 40% of a 0.25% increase on 14 September. Barring new shocks, investors anticipate that the ECB overnight deposit rate will not exceed 4% in this cycle and that it will first be cut by mid-2024 (see Chart 4).

Chart 4. Eurozone 3-month interbank rate implied in futures contracts

Source: LSEG Data & Analytics and EFGAM calculations. Data as of 11 September 2023.

The market would therefore experience a negative shock if instead the ECB raises rates or signals that more rate increases are likely at future meetings. However, downside risks to growth, falling inflation and recent market volatility should prevent the ECB surprising markets with an overly hawkish stance. Refraining from raising rates in September while keeping all options open would be a market-friendly compromise between the hawks and the doves in the Governing Council.